3 Things Worth Thinking About

The first half of this week has been very interesting from an economic, financial and geopolitical viewpoint. Despite what appears to be globally increasing risks, the financial markets have seemed relatively unfazed. Historically, such calm has always existed prior to the eventual storm. This week’s “3 Things” takes a look at some of the “rising risks” that I believe are being ignored which could potentially be harmful to individual's portfolios.

(Note: Identifying risks does not mean to “sell everything and run to cash.” As noted in this past weekend’s newsletter that discussed the markets recent “sell signal”:

'The current 'sell' signal does not mean 'panic sell' everything you own in your portfolio and run to cash. Initial sell signals can be short lived particularly when the Federal Reserve is still intervening in the markets.

Furthermore, by the time a WEEKLY sell signal is issued the markets are already OVERSOLD on a short term basis. It is very likely, that a rally will ensue in the markets over the next week back to resistance that could be used to rebalance portfolios and reduce the risk more prudently.”

By being aware of “risks,” we can make better portfolio allocation decisions in order to preserve capital and produce better-long term returns.

Oxymoron

There is an interesting phenomenon occurring in the financial markets that absolutely, positively, will not last indefinitely – the “Giant Shrinking Correction.” The chart below shows the S&P 500 (weekly closing data) since the beginning of 2009, with all relevant corrections identified in terms of percentage.

There are two important points to note. First, each correction since the end of QE2 has been increasingly smaller. This is very much in line with a prediction made in November, 2013 by John Hussman when he stated:

“A discussion of bubble risk would be incomplete without defining the term itself. From an economist’s point of view, a bubble is defined in terms of differential equations and a violation of ‘transversality.’ In simpler language, a bubble is a speculative advance where prices rise on the expectation of future advances and become largely detached from properly discounted fundamentals. A bubble reflects a widening gap between the increasingly extrapolative expectations of market participants and the prospective returns that can be estimated through present-value relationships linking prices and likely cash flows.

As economist Didier Sornette observed in Why Markets Crash, numerous bubbles in securities and other asset markets can be shown to follow a ‘log periodic’ pattern where the general advance becomes increasingly steep, while corrections become both increasingly frequent and gradually shallower. I’ve described this dynamic in terms of investor behavior that reflects increasingly immediate impulses to buy the dip.”

Secondly, I have noted in the chart above (red vertical dashed line) the onset of the most recent QE program. As noted, corrections since December of 2012 have never taken the markets back to extremely oversold levels as had occurred previously. With the Federal Reserve now reducing monetary interventions, it is likely that volatility will increase and corrections will once again become deeper.

The issue, as discussed by Hussman, is the current “risk on” environment will most assuredly swing to “risk off.” It is at this point that most investors are paralyzed into inaction as the realization of what was said “could not happen,” does.

Stanley Fischer And The Structural Shift

This past Monday, Stanley Fischer, the official who took over as Vice Chairman of the Federal Reserve in June, commented that the weak economic recovery might simply be continued fallout from the financial crisis and subsequent recession. However, “it is also possible that the underperformance reflects a more structural, longer-term shift in the global economy.”

I spilled some digital ink on his comments yesterday discussing the impact of debt and consumption on the “structural shift” in economic growth. However, my good friend Doug Short really hit home with his destruction of the “labor force is a function of retiree’s” meme.

“[The following chart]…essentially demolishes Fischer's view of our aging population as a demographic drag on labor supply. Here is the ratio of the 65-and-over cohort as a percent of the employed civilian population all the way back to 1948, the earliest year of BLS employment data. Mind you ... these people are not only in the workforce, but also actually employed.”

“The percentage of elderly employment is at its historic high -- now double its low in the mid-1980s. This is a trend with multiple root causes, most notably longer lifespans, the decline in private sector pensions and frequent cases of insufficient financial planning.

I would dismiss Vice Chairman Fischer's reference to ‘considerable uncertainty’ in the interpretation of labor supply weakness as routine Fedspeak. We are most certainly experiencing a structural change in employment, one that is a major drag on the overall economy. The fact this change was (not surprisingly) exacerbated by a business cycle downturn should not blind us to its structural nature. While this change will not be permanent, it will be a burden on economic growth for many years to come.”

The following chart is food for thought. There are extremely high expectations that the U.S. economy will achieve “lift off” in terms of economic growth eventually achieving 3-4% annualized growth rates. The chart below shows the nominal GDP of the Eurozone and U.S.

Is it possible, that in globally interconnected economy, the U.S. can stand alone?

While there are many prognostications that a recession is “nowhere in sight,” it is important to remember that recessions are a function of REVISED economic data. In other words, the reason that the National Bureau of Economic Research has never predicted a recession is because they must wait for the revisions to past data to determine the start and end dates of recessions.

However, it is also important to remember that as shown in the table below, it is often quite common to see strong economic data just before the onset of a recession.

While the Q2-2014 GDP print of 3.9% was certainly welcome following a dismal Q1, with Japan and the Eurozone economies slowing markedly, the spillover into the U.S. will likely be seen in Q3. As noted in the NYT, by David Jolly,

“Economic growth in the Eurozone sputtered to a halt in the second quarter as Germany contracted, and France stagnated again.

The gross domestic product of the 18 nations that share the euro did not expand at all from the first quarter of this year, when it grew 0.2 percent, according to Eurostat, the European Union’s statistics agency in Luxembourg.

As shown in the chart above, it is not uncommon to see a spurt of economic growth prior to the onset of a recession. Just as important is that recessions tend not to be a gradual thing, but rather a sharp plunge in activity caused by some exogenous event (oil prices, terrorism, war, etc.)

It will be worth watching the income data closely in the months ahead. Sluggish retail sales, very weak imports, and the drag on exports due to our trading partners economic drags (which makes up about 40% of corporate profits) suggest that Q2 may be the best we see this year.

Nah - like a hot air baloon with an expanding rip in the side. To keep the balloon aloft, the operator keeps increasing the size of the fire, which works for a while, until the whole thing catches fire.

If we had access to internal, classified documents, here's one we would see:

"Due to the events since 2008, and onsuing geopolitical risk, the US economy is now part of the greater National Security Initiative. It is of utmost importance that the civilian population be prevented from discovering the true state of affairs facing the United States at this time, as it would greatly alarm them, making this current situation even more unmanageable. Should an unexpected shock occur, assume we will fall back to Operation Fortress America, where the President will declare a state of emergency and hand over public administration to FEMA. This will allow the President and his council to address the threat facing our nation."

Nothing wrong with the charts and forecasts here, what cannot be forecasted is the silly amount of money pumped, and duration this regime is willing to go to make everything appear fine. Without the trillions of pump, the forecasts would have verified a long time ago.

Do you think things are better off now than in 2008/2009 (fundamentally speaking)?

dips of any duration are V bottoms - probably institutions with newly minted cash that slam the market higher

so the game is short squeeze - but why? bag holders typically found at the top are retailers - this time around it appears as though institutions and share buyback companies are the bag holders - the only way to make a profit is to jam the shorts and drive the market higher when shorts cover

only one problem - shorts are smaller and holding their position - now moves up have to come from BTFATH buyers - have fun with that - a few more ZIRP bonds you say?

Well no shit, bitch. As was pointed out on ZH earlier, the Japanese central bank has a 1% rule - any dip of more than 1%/day results in liquidity oozing out into ETFs and the like. Gotta keep those animal spirits up! No, you can't go home, here's another shot! What, your throat is all raw? Take it as a suppository. And that wasn't a suggestion.

What bothers me is that when the Black Swan arrives we will all think it is a mocking bird because we have been conditioned to think that nothing can knock the market down. Neither war, pestilence, riots, grim economic news, or heads and shoulders have fazed this market ... it just plods higher and no one, in the Msm is even surprised.

The transversality condition requires the state variables to converge to zero as the planning horizon tends towards infinity. Bubble conditions violate transversality in the sense that the state variables of the bubble imply a future condition of infinite debt. This is intuitively the point at which market expectations become decoupled from balance sheet fundamentals.

"A necessary condition for optimality in variational problems with variable end-points. The arbitrary constants on which the solution of the Euler equation depends are determined by means of the tranversality condition. The transversality condition is a necessary condition for the vanishing of the first variation of a functional."

The Math just describes the way that Extremely Massive Stars implode into Black Holes when Boundaries are exceeded due to the diminishment of Fusion Pressure from within the core after exhaustion of Nuclear Fuel.

You get this really fast expansion as some material inflates outward while most mass deflates and collapses into the singularity. That is called the Supernova Event...

Inflation and Deflation coincidentally...really coinherently to the same phenomena as it is a requirement. Who'd of thought that possible?

There is usually no warning as it just...well...er...happens.

It is nothing to concern yourselves with. Who cares about this Physics and Math shit anyway??? It is only for those nerds and geeks.

Besides...The US Government decreed that the laws of Physics were Null and Void starting on September 11, 2001.

Your Government knows what is best and they have your best interests at heart.

It looks like the population wants to squeeze every last possible nickel out of the market until it becomes overwhelmingly obvious we are doomed. For most Americans, they'll realize that when it actually happens. They wake up just in time to take the bullet.

Sometimes the old guys who have seen it all have the most perspective and the guts to speak up because they have less to lose. What I like about numbers is that when they are not jockeyed, jerked around, and falsified they tend to tell the truth. Looking down the road the numbers do not work.

Allen H Meltzer is viewed by many economist as America’s foremost expert in monetary policy, Meltzer is the author of the three-volume “A History of the Federal Reserve.” For over 25 years he was the chair of the Shadow Open Market Committee, a group that meets regularly to discuss the policy of the Federal Reserve. “We’re in the biggest mess we’ve been in since the 1930s,” he recently stated. “We’ve never had a more problematic future.” More on his thoughts in the article below.